Q: What is the history of the fund?
Our track record for this strategy dates back to when I started at the firm, in 2003, at which point my team and I managed large closed-end funds and individual accounts. In 2010, the firm decided to try offering an open-end fund. Today the open-end fund is around $6.8 billion, reflecting investor appetite for fixed income and the high income it pays combined with the risk-adjusted and absolute returns we generate that beat those of our competitors.
Before this, I worked at the Federal Reserve, in bank supervision and on the Open Market Desk. This background has proved useful as a large percentage of the securities we invest in are issued by financial companies, and of course monetary policy is very pertinent. I also worked at Merrill Lynch in the treasury area and later in fixed income strategy.
The global platform Cohen & Steers provides contributes to our ability to generate alpha. We have trading desks in Hong Kong, China and in London, U.K. providing access to offshore transactions. One reason our competitors’ funds do not necessarily invest as broadly as we do is because firms cannot freely participate in such transactions without an offshore presence.
Q: What is your investment philosophy?
The primary mission of the fund is income, followed by total return. We look for strong income opportunities globally, across capital structures and in below-investment-grade as well as investment-grade securities. Generally speaking, we seek the best risk-adjusted returns, with risk measured in terms of volatility.
We determine which securities offer the best risk-adjusted returns based on how we view the fundamentals of the companies, the fundamentals of the securities and of the market in general. When we identify attractive securities, we assume fairly concentrated positions, but typically don’t own more than 5% in any particular name.
When we manage the fund, we manage as a team. There are currently six people on the team, and when we discuss securities, we do it as a group. It does not matter which individual is covering that security or name—we always do it as a group. We take a hard look at what the probability of our being right versus wrong is, as that can influence the weightings as well as whether we even participate. It’s rarely black and white, but instead varying shades of gray.
Q: Do you have a benchmark?
We use a combination of two benchmarks. One is the BofA Merrill Lynch Fixed Rate Preferred Securities Index and the other is the BofA Merrill Lynch Capital Securities Index, the difference being that the Fixed Rate Preferred Index is mostly exchange-listed preferred securities while the Capital Securities Index comprises over-the-counter-traded preferred securities.
Q: What is your investment strategy?
It’s less an arrow, from where we start to where we end up, than a circle. It begins and ends with the fundamentals of the companies we invest in. We need to feel comfortable with the fundamentals and the direction of the fundamentals, the quantifiable, but also the intangibles, the quality of the management and the organization in general, and the standing in the market. That’s our bottom up.
In terms of portfolio construction, however, we are very much top down, driven by our views on markets. Because we are global investors, the political climate is also a consideration. Events like Brexit and the coming Italian referendum do play a role.
With any kind of credit type fund, such as ours, the big picture consists of where you stand relative to rate risk and where you want to stand relative to credit risk. Our macro views help us to determine that, plus calculate industry and country overweights and underweights. You could even say it guides our overall allocation, because many of the things we invest in are not necessarily in our benchmarks.
So, we marry the bottom-up fundamentals of the company and top down macro to select securities. If we look, for example, at the securities of company X, sometimes we choose a security more sensitive to rates and sometimes one more sensitive to credit. The only way to tell what is rich and cheap is if we maintain a macro view. Macro plays a substantial role in terms of deciding what to invest in.
After that, we consider our portfolio-specific requirements—liquidity in the portfolio and concentration risks—to ensure we do not invest too much in any particular spot. At the end of the day it is a marriage of the two, the top down and the bottom up, which meet at the security valuation standpoint.
Q: Can you give an example of the kind of bottom-up analysis you do?
Once we agree upon the macro, we focus on those securities best suited to our macro view. We have analysts who are responsible for specific securities. If one of our analysts wants to present their idea of, say, a preferred security of a U.S. bank, they do so, but in the context of the valuations of the other securities they cover.
Now, because preferred securities are subordinated to the senior debt of these companies, we consider the subordination premiums—how much we would be paid relative to the company’s senior debt and how that compares with other subordination premiums. Someone who covers, e.g., European banks, would share what Europe’s subordination premium looks like and whether it is expensive or cheap relative to other securities we cover. And our insurance analyst would indicate what subordination premiums look like in insurance.
If the subordination premium of that security is relatively less than that of a European bank, we assess whether that represents a better risk-adjusted return. The European bank security might have a higher subordination premium, and it probably has a higher income rate, but what might drive our views on value could be the political environment, the regulatory environment, or other factors close to the issuer. Sometimes you see securities that appear cheap, but that’s because there is a good supply of similar securities behind them or other good reasons.
Q: How does your research process enable you to find opportunities?
The more spread there is, the more research we put into it. Meeting management is extremely important to us. While some companies are big enough and well known enough where we do not need to spend substantial time with management, when you’re talking about companies where we know considerably less or where risks are higher, we spend a lot of time talking with the management team.
We make plenty of field trips. I was in London a few weeks ago at a conference of European banks and insurance CEOs. We have an analyst covering them, but I like to talk to them directly to peg down the macro so I feel comfortable with what is going on. Having more than one set of eyes is beneficial, particularly where there exists higher beta, and in higher-risk areas. We are willing to allocate more resources in order to do just that.
We are consensus oriented, but as the portfolio manager, I do have veto power. That said, I rarely disagree with my analysts. The whole team sits down and sometimes we spend an entire day parsing every entity in the portfolio. We involve the whole team in this because we believe that it provides every analyst with a better view of where real value exists across the whole portfolio, not just within their area of coverage. Everyone has input on every decision.
Occasionally I have a different view, or maybe there are other factors to consider, like if we want to take tax losses or tax-related gains, or maybe we need to generate cash because of an outflow, we have to pay a dividend—something like that.
Q: What is your portfolio construction process?
Portfolio construction is driven more by what we think is cheap versus rich, although naturally you can’t know something is cheap unless you are aware of how it compares to other securities.
Our goal is to generate substantial income. Consequently, we want to construct the portfolio according to where we can find income.
When spreads collapse in a particular part of our global market, we will move to a different part of the market, always following the income, but making sure we know why the income is there. If a security has cheapened for a reason, we want to know what that reason is, and if so, does the security, the sector, or the geography fully compensate us for whatever that reason is.
As an income fund, we can buy any kind of income-related securities, but because our focus is preferred securities and income, generally 95% of the portfolio is in preferred securities. (In Europe, they are known as capital securities, and in Asia, hybrid securities.) Essentially they are the subordinated obligations of various companies.
Q: What specific types of investments do you make?
We like to invest in subordinated pieces of high quality, investment-grade companies because we get a lot more in the form of that subordination premium, but they are not always investment-grade companies. Forty percent of our portfolio is below investment grade at the security level.
Just as an example, Bank of America’s senior debt is rated A-, but their preferred securities are rated BB+, making them below investment grade. That is not uncommon.
In some cases we may invest even in non-rated securities, for instance in REITs, real estate investment trusts. We know those companies well because Cohen & Steers has a very large team covering REITs, as well as infrastructure, the utility space, and to some extent financials. In fact, we are the largest manager of REITs in the world. And so we draw on the resources of our equity teams here. Every day I meet with all our other portfolio managers to discuss macro and world events.
From a portfolio construction perspective, quality matters, but it is not the driving force. We typically like to maintain a BBB- quality in the portfolio, but as everyone knows, environments change. This fund started after the financial crisis, not before, but we were managing this strategy in other funds before and during the financial crisis and owned a lot of senior debt, not just subordinated debt, because we did not like some of the risks in subordinated debt. We go where we need to in order to protect the portfolio and our investors.
We will also add more beta to the portfolio, and can and do invest in convertibles, although those do tend to be low-beta convertibles, not what one would get in a typical convertible fund. They are busted income-oriented convertibles.
Q: How do you define and manage risk?
Risk in these contexts equates to volatility, standard deviation, but it is also can be looked at in different timeframes. Our fund pays almost 6%. If you think of the fund as a 12-month investment, then as long as the fund does not fall by 6% or more, it will feature a positive total return.
There is short-term volatility and then the total return, which includes high income. We are relatively active managers, so if we have a view on rates or credit, we actively buy and sell securities and alter the portfolio. I prefer to protect against what we cannot develop a view on, or quantify.
For instance, with the Brexit vote approaching, we bought puts on British pound sterling because we had investments in Europe and there was no rational basis for assuming that poll results alone could reliably predict Brexit would not happen, not when they weren’t our research. We bought the puts on the pound at a payoff of 5 to 1, which proved smart. We would not have done that had it not been cheap, but it was cheap. That is just one example of how we approach a risk environment.
I meet as part of a risk committee twice a year, which includes our chief compliance officer, legal officer, and chief investment officer. We put together ten pages of information concerning risk in the portfolio and discuss those things. There is also frequent follow-up.
We also have a risk group looking at our forecasted tracking error every week, and to the extent that our forecasted tracking error moves in a material way from the past, I am called upon to explain why to our risk people and to my chief investment officer.
